Diary of a Financier

Bookshelf Update: Brian Sack, PM with Largest AUM in World History

In Bookshelf on Thu 21 Jul 2011 at 08:58
  • Brian Sack speech on FRBNY Open Market Accounts; he says:
  • Duration 4.5 yrs v. 2-3 yr average.
  • Interest rate risk $1.5T v. $500B average.
  • QE2 was the only policy tool at Fed’s disposal, and it wasn’t designed to stoke growth or employment.
  • Recent volatility is not from QE2 end, but from broad crises risks.
  • QE3 could reproduce QE2, adjust SOMA portfolio durations to affect yield curve, or telegraph SOMA purchases/sales to manipulate markets.

Federal Reserve Bank of New York’s Brian Sack is a portfolio manager in charge of the Fed’s System Open Market Accounts (SOMA).  He’s the guy who actually trades securities for the Federal Reserve & Quantitative Easing. At $2.6T AUM, these SOMA portfolios make Mr. Sack the world’s biggest (most important) portfolio manager.  He delivered a speech yesterday, discussing the Fed’s duration risk, interest rate risk, QE2’s strengths/weaknesses, and options for QE3.

This is a must read.  Excerpted from that speech:

POMO (Permanent Open Market Operations)

Over the life of the program, we conducted 140 outright purchase operations to meet the directive set out by the FOMC. That meant that we were active on nearly every day possible over that period. In those operations, the Desk bought $767 billion of Treasury securities, which included the $600 billion expansion of the portfolio and $167 billion of reinvestments. Our operations ranged in size from just over $1 billion to around $9 billion, with an average size of about $5.5 billion.

Those operations brought the amount of domestic assets held in the SOMA portfolio to $2.654 trillion. The current directive from the FOMC instructs the Desk to continue to reinvest the principal payments on all domestic assets held in SOMA into Treasury securities. Thus, the amount of assets held in the SOMA will remain at that level until the FOMC decides to change the directive.

Of course, the portfolio at these levels is unusually large. In the absence of the asset purchase programs, the size of the SOMA portfolio would be around $1 trillion, as required to meet currency demand and other factors. Thus, the Federal Reserve has about $1.6 trillion of additional assets in the portfolio as a result of its asset purchase programs.

The SOMA portfolio also has different characteristics than it would have had in the absence of the asset purchase programs. Most notably, the overall duration of the SOMA portfolio at the end of June was over 4½ years, compared to its historical range of between two and three years.

SOMA (System Open Market Account) Interest Rate Risk

…the SOMA portfolio holds about 18 percent of the outstanding stock of Treasury securities. Our share of the market is even higher at intermediate maturities, where our purchases were concentrated…

…the larger amount and longer tenor of our securities holdings result in a considerable amount of duration risk in the SOMA portfolio, meaning that the market value of the portfolio is sensitive to movements in interest rates. One measure of this risk that is familiar to market participants is the concept of “10-year equivalents,” or the amount of 10-year notes that would produce the same degree of overall interest rate risk. At this time, we have about $1.5 trillion of ten-year equivalents in the SOMA portfolio, which is about $1 trillion above the amount that we would have under our traditional portfolio approach.

QE2 Effectiveness- LSAP (Large-Scale Asset Purchases)

One criticism that has been directed at the LSAP2 program is that it was unable to restore vigorous growth to the economy. I think this is a reasonable observation but not a strong criticism. It is true that the support to growth provided by the asset purchases appears to have been countered by other factors that have continued to weigh on growth. However, the LSAP2 program was never described as such a potent policy tool that it could ensure a return to robust growth and rapid progress toward full employment in all circumstances.

Despite its limits, the expansion of the balance sheet was seen by the FOMC as the best policy tool available at the time, given the constraint on traditional monetary policy easing from the zero bound on interest rates. The willingness of the FOMC to use this tool is indicative of a central bank that takes its dual mandate seriously and does what it can to deliver on it. The disappointing pace of recovery that has been realized since then suggests that the additional policy accommodation provided by the LSAP2 program was appropriate.

 On Recent Volatility

The pace of the Desk’s purchases fell back sharply at the end of June, as we moved from expanding the portfolio to simply reinvesting principal payments. In particular, our purchases slowed from an average pace of about $100 billion per month through June to an anticipated pace of about $15 billion per month going forward. We do not expect this adjustment to our purchases to produce significant upward pressure on interest rates or a tightening of broader financial conditions, given our view that the effects of the program arise primarily from the stock of our holdings rather than the flow of our purchases. While there has been considerable volatility in Treasury yields over the past several weeks, we attribute those movements primarily to incoming economic data and to broader risk events.

On QE3

Given the considerable amount of uncertainty about the course of the economy, market participants have observed that the next policy action by the FOMC could be in either direction. If economic developments lead the FOMC to seek additional policy accommodation, it has several policy options open to it that would involve the SOMA portfolio, as noted by Chairman Bernanke in his testimony last week. One option is to expand the balance sheet further through additional asset purchases, with the just-completed purchase program presenting one possible approach. Another option involves shifting the composition of the SOMA portfolio rather than expanding its size. As noted earlier, a sizable portion of the additional risk that the SOMA portfolio has assumed to date came from a lengthening of its maturity, suggesting that the composition of the portfolio can be used as an important variable for affecting the degree of policy stimulus. Lastly, the Chairman mentioned that the FOMC could give guidance on the likely path of its asset holdings, as the effect on financial conditions presumably depends on the period of time for which the assets are expected to be held.

Alternatively, economic developments could instead lead to a policy change in the direction of normalization. The FOMC minutes released last week provided valuable information on the sequence of steps that might be followed in that case. The minutes indicated that the removal of policy accommodation was expected to begin with a decision to stop reinvesting some or all of the principal payments on assets held in the SOMA. If all asset classes in the SOMA were allowed to run off, the portfolio would decline by about $250 billion per year on average over the first several years.

–Romeo (hattip Tyler Durden)

  1. […] called. So far, the Fed tactics are all according to the playbook proffered by FRBNY SOMA manager Brian Sack back in […]


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